Over the last six months, our infrastructure and construction stocks have run up by a massive 200% as against returns of 73% from the Sensex and 112% from the Capital Goods Index. The sharp rally has been spurred by hopes that the recently elected, pro-reform government will boost spending on infrastructure, eliminate policy bottlenecks, and simplify procedures for project approvals.
The surge in stock prices is also a function of a re-rating in the broader market multiple, led by the restoration of liquidity flows. Last year, the construction & infrastructure sector suffered a major blow as India’s economic growth slowed from 9% in 2007–08 to below 7% and the global credit crunch starved infrastructure firms of funds.
Now, with healthy liquidity conditions, strong project execution, softening commodity prices, lower interest rates, and a healthy political climate, we expect upgrades to consensus earnings estimates in H2FY10, leading to a further re-rating of the sector. High-growth mid cap construction stocks look set to take the lead.
Infrastructure spending of ~$ 500 billion in the 11th Five Year Plan and additional spending through government stimulus packages provide strong revenue visibility for infrastructure players over the next 4–5 years.
At the same time, a rebound in economic growth and corporate capex along with improved availability of funds augur well for the sector. Public sector investments will be crucial going forward, with roads, irrigation, power and urban infrastructure likely to attract a bulk of the development funds.
Outlook and valuation
Although we expect lower revenue growth at ~20% CAGR over the next two years on account of the higher base, we anticipate a healthy bottomline ramp-up of ~26% led by rationalization of interest costs.
With strong earnings growth, we firmly believe that valuations of our mid cap construction universe remain attractive at a P/E of 15.9x FY11E earnings and 12.7x excluding subsidiaries.
While we expect stock performance to be volatile in the short term, we see opportunities for above-average returns in companies that have a strong track record, a sturdy financial backbone, and robust riskmanagement systems with the ability to scale up. As mentioned, softening commodity prices and lower interest costs offer potential for earnings upgrades.
We remain positive on L&T and Punj Lloyd in the large cap space, IVRCL Infrastructures and Simplex Infrastructure in the mid cap space, and IRB Infrastructure in the developer segment.